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August 3, 2014

A Healthy Stock Market Needs These 3 Sectors

Several industries are key to a healthy economic recovery and sustained equity market performance

Although the S&P 500 and Dow Jones Industrial Average have seen new highs this year, some areas within the stock market aren’t participating in the rally.

Small cap ETFs, for example, linked to the Russell 2000 (IWM) and S&P SmallCap 600 (IJR) continue to lag the broader market. Investor risk appetite for higher beta/higher risk small cap stocks is waning, which partly explains why they aren’t leading the market.

Elsewhere, the homebuilding (ITB), retailing (XRT), and regional bank (KRE) industry sectors have not participated in the 2014 rally to new highs. Why does this matter? Because performance divergences, especially in key industry sectors, are either supportive or non-supportive of the broader stock market’s move.

Furthermore, it would be a mistake to overlook the importance of homebuilders, retailers, and regional banks not just for the stock market, but the broader economy.

Consumer spending accounts for roughly two-thirds of national GDP and a robust housing market is central to any economy that’s alleged to be growing.

Although consumer stocks (XLY) have trailed the S&P 500, consumer confidence according to the Conference Board, hit 90.9 in July--its highest reading since the onset of the Great Recession in October 2007. Of course, how finicky consumers feel today is a lagging indicator, but it’s still better to see them in a generally happy mood.

Nationwide home prices in 20 major cities grew just 9.3% in the year ended in May compared to a recent peak of 13.7% last November. Data from the homebuilding sector has been worse. New home sales sank 8.1% in June and homebuilding stocks have slid 9.7% year-to-date.

The performance of regional banks gives us a compact view of local economies and they’ve fallen almost 4% since the beginning of the year. While equity bulls may look the other way, regionals are heavily represented in the small-cap finance portion of the Russell 2000 (almost 25% sector exposure).

In summary, homebuilders, retailers, and regional banks are three industry sectors crucial to both the economy and the stock market. Healthy markets need them as participants rather than lost observers.

For Q2'14, the U.S. GDP gained 4% after a rough first quarter. And if further gains are ahead, consumer stocks, homebuilders, and regional banks will need to be right in the thick of it.